Night of the Living Board of Directors

Bottom Line: Board tenure has an inverted U-shape relationship with firm value, affecting several aspects of corporate performance. The turning point comes around the nine-year mark, when the value of directors’ firm-specific learning is eclipsed by their growing entrenchment and lack of independent oversight.

The principal job of the board of directors of any company is to oversee the performance of top managers and provide dispassionate guidance on the company’s strategic direction. Board members acquire valuable firm-specific knowledge in their first few years at a company, but that value is offset as they become more entrenched in the company’s mind-set and gradually lose their independence. The question is: How does the average board tenure affect firm value?

According to this paper, the first to empirically examine the question, board tenure displays an inverted U-shape relationship with firm value. Up to a point of about nine years, the author found, the accumulation of a board member’s knowledge about the firm leads to progressively better corporate decision making, even as the board member retains his or her independence. This is reflected in a wide range of firm activities, including more effective mergers and acquisitions, more thorough disclosures of financial statements, a higher likelihood of innovation, a higher probability of replacing a poorly performing CEO, and less backdating of executives’ stock options.

But members can learn only so much, and as their tenure advances beyond the nine-year threshold, they slowly morph into “zombie boards,” the author says. They drift away from effective monitoring practices and become stuck in the status quo, initiating activities that drive down shareholder value.

Combining several databases, the author examined more than 2,150 firms on the S&P 1500 from 1998 to 2010. Board members’ tenure ranged from a few months to 31 years. In a series of analyses, he found that firm value—as measured by the market value of a company divided by its assets—reached its maximum when board members had an average tenure of nine years. This finding held when the author controlled for numerous variables, including firms’ opportunity for growth, size, complexity, board diversity, and different CEO traits.

Overall, he found that directors’ tenure was negatively associated with board independence: The longer their average term, the less likely they were to act in ways consistent with objective oversight. And certain firm characteristics led to longer board tenure, such as higher levels of CEO ownership (suggesting that entrenched leaders want familiar advisors around them) and having more members who also served on other corporate boards.

As an illustration of the effect of board tenure, the author calculated that when the average member had served for three years, an additional year of tenure boosted firm value by 0.45 percent. Toward the other end of the spectrum—an average board tenure of 15 years—adding one more year decreased firm value by 0.52 percent for each board member above that mark.

These findings become a little more nuanced with more complex corporations. Using a subsample of particularly complex companies that operated in several different business segments or industries, the author found the same inverted U-shape relating to firm value and board tenure. However, there was more slack around the optimal board tenure for companies with intricate or multifaceted operations. These firms generally had longer-serving board members, who perhaps required more time to understand the full scope of the business. As a result, for complex or particularly distinctive corporations, the author recommends an ideal range of between seven and 11 years of service for board members.

To further test the findings, the author explored investors’ reactions to the news of an unexpected shuffling of the board. Using a sample of 151 sudden deaths of directors between 1994 and 2011, he calculated that announcements that changed the average board’s tenure resulted in an abnormal three-day boost to the company’s stock returns. This suggests that investors recognize shifts in the trade-off between knowledge and independence.

It’s tricky to get the service tenures just right, of course. Depending on the power they wield, CEOs can largely control the board selection process. Firms with staggered boards, which place strict limits on members’ tenure and allow only a few to be replaced each year, also face a unique difficulty in getting the mix right. Firms could try to bring back an experienced director to get around the entrenchment dilemma, but the passage of the Sarbanes-Oxley Act in 2002 dramatically cut down on firms engaging in this practice.

Nevertheless, the author writes, the results underscore the “time-varying trade-off between knowledge and entrenchment for board effectiveness,” which should be carefully considered when companies design their board structure and weigh how much influence the CEO should have on directors’ selection. Although the United States doesn’t institute restrictions on board tenure, some other countries have deliberated imposing term limits on directors. In light of the ongoing debate, companies may want to reexamine their board composition and try to attain a better blend of knowledge and independence.

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